A damsel on the verge of distress

This is an excerpt from a story that originally appeared in the June edition of AsianInvestor magazine. To learn more about the content in the magazine, please contact Stephen Tang at [email protected] or on +852 2122 5239.

In the silver screen era, a damsel in distress was inevitably spared from having the locomotive strike her. In the tales of the Brothers Grimm, Rapunzel escaped from her distressed situation in the tower thanks to her unfeasibly long hair.

The real world offers no unlikely or implausible rescues. Distress is real and distressed companies are back.

"Every time this comes around it seems as though the lessons haven't been learned," says Hong Kong-based David Putnam of M&A firm Houlihan Lokey. "There is a new guy steering the boat and he doesn't know where the rocks are."

In Asia we are used to floundering companies and banks, thanks to the financial crisis of the 1997/98.  Balance sheets of countries and companies are currently in better shape in Asia than elsewhere in the world; specifically they are less leveraged. Until now, there has not been the same level of default rates in Asia as have occurred in other countries. If distressed situations do start to proliferate, then we can expect to see the asset-management companies that were established after the Asian crisis to deal with banks' dud loans springing back to life.

"Because of the shutdown of public markets there is an unprecedented opportunity for distressed debt," says Robert Appleby of ADM Capital in Hong Kong, a distressed investment specialist. "We're in a perfect storm, but it is hard to find things to buy. Banks are tending to hold on to their non-performing loans. Profit for distressed funds is made by buying in at the right price, but how low do you want to stoop to get the 20% return you aim for? It is so much easier to put right an intrinsically good company than the bad ones. After 1997, we spent a lot of time fixing bad companies, and you have to be mindful of the time value of money."

Furthermore, what is the bid price for a company whose function is redundant in modern times? (General Motors comes to mind.) If a company's day in the limelight is over, and its technology is outdated, then why try to rehabilitate it? You can still lose all of your capital on a 10-cents-on-the-dollar investment, if the price later falls to zero.

So what needs to be done? It may be something as simple as financial analysis, the skill that all the banks were supposed to have been practicing in the first place.

"What we call 'rescue financing' is what needs to be done, and that involves credit analysis company by company," says Robert Petty, managing partner at Clearwater Capital Partners in Hong Kong. "The top-tier guys will win and get the refinancings. If you are the number five in a sector, then there is less reason to exist and for those we may see some ugly restructurings."

Clearwater Capital identifies China's solar energy sector as being an area in which the top participants will emerge as the global leaders in the industry, and therefore if an interest can be picked up at a good price, then it may be worth buying. Clearwater feels likewise about property in China, which they assess at a price of 30 cents to 50 cents on the dollar as being a good counter-cyclical play. That is because they perceive China's property sector woes as being two years ahead of those in the United States.

Know your rights

Operating in the distressed sector is as tricky as ever, though. The industry is intensively legal and process driven and the countries that are best set up to allow this to proceed smoothly will get the most capital from distressed investors.

"An investor cannot go in with an aggressive Western approach to distressed shouting out what his rights are. He might still secure a liquidation, but it would be an offshore liquidation with no assets," says Scott Bache, a partner at Clifford Chance in Hong Kong. "So there needs to be private-equity style structures, such as onshore veto rights and board representation. The restructurings that are successful will have these features."

There is an enshrined sense of order in a wind-up situation, and the concept is that certain people get paid out first. Each country has a variant on this methodology, usually with the shareholder being last in the line.

"I like companies which have assets," says Anurag Das of Raintree Capital. "The management are free to leave - that is a problem - but it is not as bad as having no assets. Some companies appear to have assets, but then in reality they don't, if someone has a charge over them."

This is where it is important that a country's legal system does preserve those rights. Attempts in the US to hand over a lion's share of Chrysler to government and unions was rightly resisted by holders of fixed-income instruments, whose claims technically and legally ranked ahead of those of trade unions and employees. The company then entered into Chapter 11.

If governments try to fiddle with the order in which creditors are treated for political reasons, then that will result in lower appetite for people to invest in distressed situations and a push by higher ranking creditors to enter into bankruptcy proceedings rather than thrash out a deal that may see their interests prejudiced or haircut.

"De-leveraging is difficult when a government is trying to stimulate growth," says Professor Edward Altman of New York University's Stern business school, and an expert in corporate defaults. "The quickest way to de-leverage is to go into bankruptcy. Currently I calculate $2 trillion of distressed assets being chased by $250 billion in funds. In that case, distressed prices should continue to fall."

Waiting for doom

How have the distressed and special situations funds performed? So far, they are not doing very well. In 2008, the average distressed fund was down 26%, with redemptions of 30%. Professor Altman adds: "You had to be short credit to make money. If you were long credit not only did you lose money, but you had to deal with the redemptions as well."

Distressed debt and special situations funds are long credit by nature. They take on their investments and they then try to work them out. Therefore, if they had acquired their positions before the crisis, those long positions are even more illiquid and underwater than they ever were before, unless a workout miracle has taken place.

Even if a distressed fund is shipshape, and has not resorted to side pocketing the fund or placing gates and suspensions on redemption, it can still be hit hard by events beyond its control. If other funds holding similar positions get into difficulty and hold a fire sale of their positions, prices of assets fall, stymieing our first manager's net asset value. This unfortunate situation has trapped many managers since September 2008, but in the more illiquid world of distressed, the effects appear to be magnified.

What this all boils down to is that it is distressed debt firms that are happiest today are the ones that have been able to raise cash and can now sit on that cash waiting for the opportunities to arrive.

Here is Catch 22, because funds cannot easily raise cash at present. But they have some time on their side.

In the spring of 2009, the distressed environment is still not yet ripe. It will take longer for companies to make payment defaults before the banks undertake a sell off of non-performing loans. Institutions have to make the decision to crystallize losses and sell off positions that have gone bad. If they have already made provision for them, that process is psychologically more palatable. If not, there is a temptation to hang on to the positions rather than sell them off cheaply. It is this mindset that will ultimately determine whether the US Treasury's Public/Private Investment Partnership program for selling off illiquid debt will succeeds or fail. It may take until the end of this year to start seeing meaningful flow of distressed instruments.

Default rates peak at the end of a recession or just after the recession has ended. So even though the markets are trying to be upbeat and government spin machines are declaring an alleviation to the credit crunch, it looks like the defaults, corporate failures and destruction of jobs are still ahead of us. It is a gloomy outlook then, unless you are a dastardly individual who ties damsels to the rail tracks.